Some light to the West
Japanese demand for European securitisations, and in particular UK mortgage-backed securities, hit a record high in recent months after the country’s banks looked to diversify away from lower-yielding domestic securities. However, central bank interventions and tightening spreads may soon smother the market, just as it gets up a head of steam.
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As UK banks over the recent period looked to improve capital efficiency by shifting financing off balance sheet, and found European investors under punitive levels of regulatory pressure, syndicate desks sought to widen the investor base – first in the US and more recently in Asia.
Discreet meetings in Tokyo in mid-2009 were followed by long periods of due diligence, first on the asset class and later individual issuers, with Japanese banks such as Mizuho and Japan Post Bank sending delegations of inspectors to evaluate the credit worthiness of individual institutions.
The time between initial contact and first investments was usually somewhere between nine and 12 months, said a few UK bankers. However, once the purchase decision was made, Japanese investors made big commitments, snapping up UK, and to a lesser extent Dutch, securitisations in enormous volumes, in some cases in ticket sizes of over US$1bn.
“Most of the issuers with significant funding plans have made the pilgrimage to Tokyo. The traffic has been two ways, with Japanese investors keen to come to Europe and kick the tyres and do a lot of in-depth analysis of this market, such as visiting various back offices,” said Miray Muminoglu, a director in syndicate at Barclays in London. “Following the investor education programme by UK banks a number of the large Japanese institutions have invested in very large sizes.”
Such was the level of demand from Japan that Santander in January opened its 2012 RMBS issuance account with a novel ¥20bn (US$255m) yen-denominated bond, sold as part of its Holmes 2012-1 deal. In February, Lloyds also sold a yen tranche in its Arkle 2012-1 offering (its second under the trust after an initial yen tranche in October 2011). Santander soon followed up with another yen tranche, privately placed off its Fosse Master Trust.
“Flush with liquidity and generally risk adverse, the Asian investor base has a natural capacity for high quality collateralised funding. This investor base has been active with programmatic investment as well driving large reverse enquiry”
While yen-denominated bonds have novelty value, Japanese investors have bought the vast majority of their European securitisations in dollars, with many choosing to swap out of the dollar exposure. There was some US$24.2bn of dollar-denominated UK RMBS issued last year, according to Standard & Poor’s, compared with just US$10.7bn equivalent in sterling.
US dollar-denominated tranches accounted for more than half of 2011 UK RMBS issuance and about one-third of first-half 2012 placements. This year sterling issuance has risen, while dollar and euro issuance has slowed, suggesting Japanese investors may have begun to expand their attentions to the UK currency.
“A lot of UK issuers have explicitly focused on developing their Asian secured platforms since the crisis,” said Oldrich Masek, EMEA head of securitisation origination at JP Morgan. “Flush with liquidity and generally risk adverse, the Asian investor base has a natural capacity for high-quality collateralised funding. This investor base has been active with programmatic investment as well driving large reverse enquiries.”
Japanese demand now accounts for around 30% of deals in the UK RMBS market, and sometimes closer to 50%, said one banker.
One of the key drivers for the issuer focus on Japan has been the deteriorating investor landscape in Europe in recent years. In the wake of the financial crisis this landscape was based on the evaporation of large parts of the investor base (asset-backed commercial paper conduits, SIVs and CDOs), and subsequent due diligence rules under article 122 (a) of Capital Requirements Directive II.
However, investor appetite will be further undermined by CRD IV for banks and Solvency II rules for insurance firms, the implementing pieces of legislation for the Basel III legislative framework.
An important provision of CRD IV is that ABS are not included in banks’ short-term regulatory liquidity ratios, meaning that the contribution to regulatory liquidity from ABS in many European jurisdictions will drop from 100% to 0%. For insurers, meanwhile, there are likely to be higher capital requirements based on ABS spread volatility.
“European regulators have been very strict in the criteria and guidelines governing securitisations, which means that some European investors can be less incentivised to hold RMBS,” said Barclays’ Muminoglu. “There has been talk in the market of pending changes in regulation that might allow some parts of ABS to be included in the liquidity ratio for banks but at this time both investors and issuers are still awaiting more certainty.”
For remaining UK-based investors the emergence of the Asian bid is a thorny issue, with large orders emanating from Japan often sweeping up new bonds, sometimes before they have even heard an issuer may be in the market.
“The demand from Asia definitely impacts our supply and it’s tough to be in competition with these guys, particularly when deals are done on the basis of reverse enquiry,” said Edward Chai, a portfolio manager at Henderson Global Investors. “Often there can be three or four large ticket orders driving deals and you see orders being cut, which is a concern.”
As European investors scratch their heads, the emergence of Japanese investors has been a significant boost to the asset class, and in 2011 and in the first half of 2012 five building societies debuted RMBS transactions. Last year, Northern Rock sold RMBS for the first time in almost two years and Virgin Money has since entered the fray, launching its first transaction in June 2012.
As part of that trend, the number of deals placed with investors, as opposed to retained for potential use as collateral in central bank liquidity operations, has held up, though still only accounted for around 20% of European securitisation volumes last year.
The credit performance of UK RMBS has remained good, with loans more than 90 days in arrears representing only about 2% of balances outstanding, according to S&P. Issuance levels, meanwhile, remain relatively low, totalling US$38.8bn last year (and US$17.1bn year-to-date), compared with US$166.2bn at the market’s peak in 2006, according to Thomson Reuters.
Strong performance in the underlying assets, combined with relatively low levels of issuance and rising investor demand, have produced a robust price performance in recent months, with spreads tightening to levels not seen since before the financial crisis.
Between 2009 and the beginning of this year, prime RMBS spreads traded in a stable range between about 130bp and 170bp over Libor. In recent months those spreads have become tighter and Santander’s Holmes 2012-4 deal priced in August at Euribor plus 75bp. The trend was also seen in the secondary market, where spreads have come in by 30bp–50bp to around 100bp.
From an investor point of view this is not an encouraging development, and in some cases may be the difference between buying and not buying.
“With less supply and higher demand it’s no surprise that spreads have come in so tight, but for many Japanese investors that might pose a problem – particularly if you factor in the price of the asset or currency swap,” said Alexander Batchvarov, international structured finance strategist at Bank of America Merrill Lynch. “The choice is to remain unhedged and not to swap out, which people might well want to do in Ozzie dollars, or to make a calculation based on the return.”
Investors may be further squeezed by central bank liquidity initiatives. Under the Bank of England’s Funding for Lending Scheme, launched in mid-July, lenders between August 2012 and January 2014 will be able to borrow from the central bank for up to four years against collateral – including securitisations – for a fee as low as 25bp per year.
“The FLS has been associated with a real drop-off of deals [for investors] in the pipeline in recent weeks,” said Chai. “That, together with demand outstripping supply has led to very tight spreads and some questions over how liquidity in the market is going to look.”
One response has been for Japanese investors to increase their focus elsewhere.
“Japanese investors were expanding their credit work to asset classes other than UK RMBS even before the FLS announcement,” said Michael McCormick, a structured finance specialist at HSBC in London. “We expect they will look to get more involved in places like Holland.”